Euro zone set to face ‘harshest test’ of the decade in 2012

Saying that Europe was facing its “harshest test in decades,” Chancellor Angela Merkel of Germany warned on New Year’s Eve that “next year will no doubt be more difficult than 2011” — a marked change in tone from a year ago,when she praised Germans for “mastering the crisis as no other nation.”

Her blunt message was echoed in Italy,France and Greece,the epicenter of the debt crisis,where Prime Minister Lucas Papademos asked for resolve in seeing reforms through,“so that the sacrifices we have made up to now won’t be in vain.”

While the economic picture in the United States has brightened recently with more upbeat employment figures,Europe remains mired in a slump. Most economists are forecasting a recession for 2012,which will heighten the pressure governments and financial institutions across the Continent are seeing.

Adding to the gloomy outlook is the prospect of a downgrade in France’s sterling credit rating,a move that analysts say could happen early in the new year and have wide-ranging consequences on efforts to stabilise Europe’s finances.

Despite criticism from many economists,though,most European governments are sticking to austerity plans,rejecting the Keynesian approach of economic stimulus favored by Washington after the financial crisis in 2008,in a bid to show investors they are serious about fiscal discipline.

This cycle was evident on Friday,when Spain surprised observers by announcing a larger-than-expected budget gap for 2011 even as the new conservative government there laid out plans to increase property and income taxes in 2012.

Indeed,even in the country where the crisis began,Greece,the cycle of spending cuts,tax increases and contraction has not resulted in a course correction,and the same path now lies in store for much larger economies like those of Italy and Spain.

In fact,economists and strategists on both sides of the Atlantic have been steadily ratcheting down their growth expectations for 2012.

“Europe is likely to have a meaningful recession in 2012,” said Tobias Levkovich,Citigroup’s chief equity strategist. While Levkovich does not see that as a significant threat to the bottom line of most American businesses — he estimates that Europe accounts for about 8.5 per cent of sales for the typical company in the Standard & Poor’s 500-stock index — the psychological effects on global markets will be magnified if political opposition to austerity increases.